Understanding Your Risk Appetite Before Investing in Mutual Funds

A viewer on our YouTube channel asks, “Sir, How can I identify my risk appetite? Please let me know the points to consider when deciding asset allocation. Thanks.” Many investors believe their risk appetite falls under three categories: low, medium and risk. They also assume risk appetite refers to “how much risk we can handle”. Both these notions are incorrect.This investment risk appetite question bears an interesting resemblance to students’ exam approach. At the beginning of each semester, I inform my class that grades don’t reflect intelligence. Instead, they indicate the effort and time management a student has dedicated to meeting the system’s requirements. Grades cannot measure intelligence. See: Do marks determine the future of our children? The system may not be perfect, but to earn the right to complain about the system, the student should comply with it as best he can.Similarly, investment risk appetite cannot be quantified. Although expensive questionnaires with objective questions like “What will you do if the stock market crashes by 50%” exist, they are easy to answer because the option “invest more and hold for the long term” seems like a clear choice, especially without real-life experience. Note: SEBI requires these questionnaires for registered investment advisors to work with clients. So right/wrong/inadequate, it is a regulatory requirement.So what does the risk appetite represent? It is a measure of well we understand the following:Where we stand wrt our finances (A) and where we need to go (B), and what we need to do about it (the path from A to B).What can go wrong in the path from A to B, and how well can we manage risk?What are the pros and cons of each investment product that we choose?In other words, risk appetite is not a measure of how much risk we can take. It is an appreciation of how much risk we should take. Risk appetite = risk awareness.No one can measure how much risk we can take with a set of questions. We can measure our understanding of the risk we must take with a set of (different, relevant and personalised) questions.So, how can we identify our risk appetite before investing in mutual funds or even a fixed deposit? In other words, how can we become risk-aware?Identify our future needs.Understand how inflation impacts these needs.How can we create a portfolio that overall (debt + equity) provides a return close to inflation after tax?Most people, except those with extremely high incomes, must have 50-70% equity in their long-term portfolios. However, most individuals possess debt-laden portfolios and limited experience in the capital market, resulting in a significant disparity between the risk they should and can take. Someone with no equity experience should not immediately invest 50% or more of their available funds into equity.Instead, investors should consider gradually investing in equity mutual funds (or stocks), beginning with 10% of their total monthly investment and slowly increasing this allocation over time. As experience grows, so does the ability to handle market fluctuations, and individuals can become more comfortable with the appropriate level of risk. Determining risk appetite is an ongoing process.In contrast, some individuals, particularly senior citizens, may want to take on more risk than they can handle. Unlike younger do-it-yourself investors, they may not have the luxury of time, making professional advice valuable.Those requiring professional advice can consult a SEBI-registered fee-only investment advisor from our curated list. Those who wish to DIY can get started here to understand how you can become risk-aware: Basics of portfolio construction: A guide for beginners.List of points to consider while deciding asset allocation:When is the money required?Reasonable inflation and return expectations from equity and fixed income after tax.How much money can I invest? The above inputs will help you decide on the asset allocation. You can use our Robo advisory tool to automatically determine the correct asset allocation for your goals and how to vary it in future to reduce risk.If there is a difference between the money I can invest and the money I should invest (calculator output), how can we arrive at a compromise? This is a tough step, and not all DIYers would get it right. If you need help, consult a SEBI-registered fee-only advisor from our list.What is my current asset allocation? How long would it take to reach the desired allocation? What is my strategy to get there? Again a fee-only advisor can make a big difference here.In summary, it is best if investors don’t assume they know their risk appetite or try to determine it with a quiz. Getting used to capital market risk is a process and can be subject to recency bias.It would take a few market cycles and consistent investing to get used to the volatility. In the meantime, investors should strive to become risk-aware. That is, they should appreciate what is required to meet future expenses and remind themselves of this if their conviction wavers. Do share this article with your friends using the buttons below. 🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users! Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1000 investors and advisors use this! 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